Pattern Day Trader Rule (PDT) Explained

The Pattern Day Trader (PDT) Rule is a regulation imposed by the Securities and Exchange Commission (SEC). Knowing the details of this rule and understanding its implications is critical if you want to be an active day trader. As you’ll see, it may seem intimidating, but we will explore ways to navigate around the PDT Rule while staying compliant with regulation.

What is the Pattern Day Trader (PDT) Rule?

The Pattern Day Trader Rule, commonly known as the PDT Rule, is a regulation imposed by the U.S. Securities and Exchange Commission (SEC) to designate traders who engage in frequent day trading activities. According to the rule, a pattern day trader is defined as an individual who executes four or more day trades within a rolling five-business-day period, using a margin account.

  • It is important to note that this rule applies only to margin accounts and not to cash accounts.
  • A day trade is defined as opening a long or short position and closing the same position in the same trading day. Common slang for this is making a “round trip.”

To qualify as a pattern day trader and not be restricted to three or less day trades in a five day rolling period, you must have a margin account balance of at least $25,000. This balance can be cash, or a combination of cash and eligible securities.

History of the Pattern Day Trader Rule

The PDT Rule was introduced in 2001 by the SEC as a response to the increased popularity of day trading after the dot-com bubble in the late 1990s. The rule attempts to prevent potential large financial losses for inexperienced traders who might be tempted to day trade without fully understanding the risks involved. By implementing this rule, the SEC tried to enforce a certain degree of caution and responsibility for beginning traders.

As we mentioned, pattern day traders are required to maintain a minimum account equity of $25,000 in margin accounts. If the account equity falls below that balance, you’ll be unable to day trade until the account is brought back to the required level. The $25,000 balance is used for a number of reasons all aimed at mitigating risks:

  • To ensure that the settlement of positions at the end of the day can be met by the broker.
  • To ensure the drawdown you may experience in a leveraged margin trade can be withstood.
  • To ensure anyone opening an account has some degree of financial stability or earning power.

Example of the Pattern Day Trader Rule

Suppose John is an active day trader with a margin account. In a given week, he executes three day trades on Monday, two on Tuesday, and three more on Wednesday. Since he has executed more than four day trades within a rolling five-business-day period, he would be classified as a pattern day trader. Consequently, John must maintain a minimum account equity of $25,000 to continue day trading without restrictions.

But what exactly is considered a day trade?

Example 1: One buy, one sell – This is one day trade.

  1. You start the day with no position.
  2. The market opens and you buy 100 shares of AAPL.
  3. At lunch you sell all 100 shares of AAPL.
  4. The market closes and you have no position.

 

Example 2: Multiple orders, one direction change  – This is one day trade.

  1. You start the day with no position.
  2. The market opens and you buy 100 shares of AAPL.
  3. Before lunch you buy another 100 shares of AAPL.
  4. At lunch you sell 50 shares of AAPL.
  5. After lunch you sell 50 shares of AAPL.
  6. Before the close you sell 100 shares of AAPL.
  7. The market closes and you have no position.

 

Example 3: Non-Leading sell  – This is one day trade.

  1. You start the day with 100 shares of AAPL.
  2. The market opens and you add to the position by buying 100 more shares of AAPL.
  3. At lunch you sell 200 shares of AAPL.
  4. The market closes and you have no position.

 

Example 4: Leading sell – This is one day trade.

  1. You start the day with 100 shares of AAPL.
  2. The market opens and you sell 100 shares of AAPL.
  3. At lunch you buy another 100 shares of AAPL.
  4. Before the close you sell 100 shares of AAPL.
  5. The market closes and you have no position.

 

How to Avoid the Pattern Day Trader Rule

The PDT Rule had good intentions, but oftentimes it is more of an annoyance than a protective measure. A very common problem is when someone uses their last day trade, and now can not close an existing position because they are “out of trades.” Although this may seem annoying, it is a limitation you must understand. The markets do not care, the regulators do not care, your broker does not care if you get caught in a trade you can’t close. This is your responsibility to understand and avoid.

One approach is to trade using a cash account instead of a margin account. In a cash account, traders are not held to the PDT Rule as long as they do not go over the cash balance available in their account for day trading.

Another option is to trade options or futures, since they are not limited by the PDT rule’s restrictions. However before trading these leveraged products, it is important to understand the elevated risks involved in trading them.

The most complex way around the PDT rule is to open multiple brokerage accounts. With this strategy you’ll be responsible for managing how many day trades you have made in each account. It’s also likely that you’ll be spreading your capital so thin that each position you take will be ineffective in generating worthwhile profits. At this stage, it would be recommended that you save more capital to open a properly sized account while refining the strategy on a demo account.

For a breakdown of how much money you should have in your account to start day trading using one of these alternate methods read this post here: How Much Money Do You Need to Start Day Trading?

Conclusion

Put bluntly, the Pattern Day Trader Rule is an annoyance for most traders. It was intended as a regulatory measure designed to protect traders from excessive risks associated with frequent day trading. Most new traders though look to avoid this headache with the work around methods listed above and will jump into day trading regardless. By at least understanding the rule, you’ll be better equipped to properly fund an account, or not get caught in the trap of not having enough trades left in a day to close a position out.